Why You Must Change Your Strategy For 2013: Here's How...

As the world turns, we must turn with it. Regular readers have seen evidence of our adaptation to the new realities of investing over the past few months as we have stressed more income, dividends and diversification. With the Fed declaring no rise in interest rates until unemployment falls below 6.5%, we are given the rare gift of "certainty" in the markets: we know our bonds won't decline based upon rising rates, at least not without some new warning or published change of direction from the Fed.

And you have seen us create some core positions in both balanced and long/short mutual funds. I believe that reallocation of assets based upon a current reading of the markets is still terribly important, but the realization that high frequency trading, special favors for big institutions, and the increasing shift of market volume to institutions (currently on a path to 80%) are not going to end anytime soon means we must have certain anchors to secure our portfolio while storms rage outside our safe harbor.

Government stimuli, pork rewards, jiggy and misleading headlines, and out-and-out fraud can keep a market going even when common sense says to get out. Miss some of those periods and you have a lot of time to make up. Most advisors deal with this by always keeping "some" money working in the same sectors they buy albeit with fewer funds. I have chosen instead to use the best of the best most-experienced fund managers who have the ability by their charter to shift quickly to fixed income or to short the weakest stocks and sectors.

I am also looking to use more sector ETFs and closed-end funds for the portion of the portfolio we use to take advantage of short-term market moves (6 months for you and me, 6 nanoseconds for Wall Street.) This is probably the biggest sea change of the past few years that leads me to use sector ETFs and funds to achieve our and our clients' goals, rather than quite so many individual stocks. The Internet has been a boon for individual investors in that we are no longer subjected to getting our portfolio information solely from our broker or advisor. But it is a terrible double-edged sword! The speed with which rumor, innuendo, and fraud combine with hasty and improperly-researched reporting has made too many investors simply too jumpy.

This chart, courtesy of one of the mutual funds I employ for our core holdings, tells the tale:

(click to enlarge)

You'll notice that about the only thing that made investors seriously panic from 1980 to 1990 was the crash on October 19, 1987. Even the huge Asian financial crisis, Russian financial crisis and invasion of Iraq in subsequent years didn't create widespread volatility. But a combination of the speed of the release of information, real and conjectured, with the twitchy fingers of institutional traders who now dominate what used to be called "investing" today make for a market that lurches from one crisis to the next.

Institutional traders, comprising nearly 80% of the market volume, do no fundamental research on the companies they buy and sell and have no interest in growing their portfolios with them. The average trader continues the day a success if they go home ant night with zero positions. Zero positions mean nothing bad can happen to them overnight. But it also means they often don't even know what it is that a company they buy and subsequently sell even does for a living.

At best, they might know that, say, Peabody (NYSE:BTU), Arch (NYSE:ACI), Penn Virginia (NYSE:PVR) and Natural Resource Partners (NYSE:NRP) are all coal companies, therefore if natural gas declines a penny, they all fat-finger their keyboards to sell "the coals." Except - this is but one example where they are wrong. PVR, through acquisitions, derives more income from transporting and storing natural gas today than they do from leasing land to coal companies. (In fact, they have never been an operating coal company, just one that leased lands to coal companies.) And NRP, once in the land-leasing business almost exclusively, via their joint venture with International Paper, now work with oil, gas, coal, wind, fracking sand and all other kinds of resource management.

The problem for you and I buying these companies is that there is no loyalty from the institutions and little from individual investors, who are being raised in an ever-more instant gratification world.

So when I bought for our portfolios fine companies like Encana, Atlantic Power, and Natural Resource Partners, it didn't bother me when supposedly "bad" earnings (off a penny) or "taking on too much debt" (to buy competitors at rock-bottom prices with assets cheaper than they could hunt for them) drove them down. In a market with adult investors rather than institutional traders and people with Attention Deficit Disorder, bargain-hunters would have stepped in to buy.

But today's - changed - reality is that institutional traders didn't know the company or care about its future prospects, unless the future meant before quitting time today. And the younger buyers among the individual investors didn't get their T-ball trophy in the first couple weeks so they Teflon'd over to something new.

I've seen scores of significant changes in my lifetime in this business and hundreds of smaller ones. I state all this just so you and I both understand: we can either rail against the changes or acknowledge that in the past few years, accelerating in 2008, institutional day-traders dominate, many investors have the attention span of a cucumber, and if an individual stock disappoints, we may as well sell with the rest of the lemmings and expect to wait not a few weeks but a few months or even years before taking a fresh look at it.

This doesn't mean we can't still make great money in the markets; it simply means we have to adjust our strategy. And not all that much, really; when I wrote Bringing Home the Gold (Dow Jones-Irwin) 24 years ago, I noted that 1/2 of the gains in any position were likely attributed to an up-move in the market itself, 3/8 were because the sector or industry the company was in was viewed favorably, and only 1/8 of the gain was likely to come from company-specific changes, enhancements, management, products or anything else. In other words, in the stock market "a rising tide lifts all boats." Back then, I even drew this pie chart to show the effect of outside forces on a company's performance.

But in an era of institutional fat fingers and investor ADD, we will have to be much more selective than ever before in choosing individual companies, and more willing to take small losses if necessary, knowing that we will still keep these on our radar for when they are totally forgotten as others multi-task on to make more mistakes.

We still enjoy a huge reservoir of fine stocks with market caps too low to be manipulated by the institutions or those which may have large market caps elsewhere but trade too little in the US for institutional machinations. We are looking, that means, for "small caps" - but not small fry! There are thousands of fine businesses out there, many of them household names, that are good-sized companies, but don't have a big market capitalization. They are more than ever in our sights, as are the non-US-based companies that trade on their primary exchanges back home but OTC in the U.S. These are our opportunities - and we will take them, every one…

The Best Sectors For Right Now

When it comes to the sector rotation portion of our portfolio, I will be using mostly ETFs and closed-end funds. Our current sector bets include Emerging Markets Telecommunications & Infrastructure (NYSEMKT:ETF), the Indonesia Fund (NYSEMKT:IF), Global's Norway 30 (NYSEARCA:NORW), Petroleum & Resources (NYSE:PEO), and Vanguard All-World Ex-US (NYSEARCA:VEU). Now, I have been to two dog shows and a goat-roping so I understand most people use the term "sector" more narrowly. Companies roll up into industries and industries like, say, hospitals, senior living, pharmacy management, ethical drugs, etc. roll up into a sector like Health Care.

In my world, a sector is any large play that encompasses a number of industries. That's why I include NORW as a "sector" - it is the 30 largest companies in Norway, arguably the nation with the most transparent and responsible governance anywhere. It's also why I would include a single-industry ETF like energy services; you own 75 companies with very different business approaches and far-flung subsidiaries in an ETF, I consider it worthy of consideration for sector rotation. For purposes of this allocation, I also consider market-capitalization-based ETFs and funds to comprise a reallocable sector. These positions, in the aggregate, comprise just 10.2% of our portfolio. We're going to bring that closer to 20%.

We'll do so by buying a small-cap ETF and a huge-cap ETF to complement our current market-sensitive S&P 500 positions, as well as a consumer staples ETF. With ETFs, liquidity counts! Since most of them vary only by slight degrees, the edge goes to those with the most daily volume and lowest spreads.

We'll also buy the huge-cap SPDR Industrials ETF (NYSEARCA:XLI) comprised of Huge industrials like GE, United Technologies, UPS, 3M, Caterpillar, Boeing, Union Pacific and Deere. This sector has lagged the market most recently and I think it's ready for a turnaround.

For our small-cap ETF, we'll go with Schwab Small Cap (NYSEARCA:SCHA). This ETF uses an index of the stocks ranked 751-2500 by market cap. The expense ratio is a miniscule 0.13%. True small-caps, but not unknowns: top positions include Thomas & Betts, Gartner, Taubman Centers, and so on. Small caps often do best early in the year. I think this year will be no exception.

These holdings will be added to our market-sensitive positions in the double S&P 500 (NYSEARCA:SSO), S&P 500 Low Volatility (NYSEARCA:SPLV), and Vanguard Total Stock Market (NYSEARCA:VTI).

The investing landscape has changed. It's up to you and I to adapt or perish.

The Fine Print:As Registered Investment Advisors, we see it as our responsibility to advise the following: we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund only to watch it plummet next month.

We encourage you to do your own research on individual issues we recommend for your analysis to see if they might be of value in your own investing. We take our responsibility to proffer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we "eat our own cooking," but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

Disclosure: I am long ETF, IF, PEO, VTI, SCHA, SPLV, XLI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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